This page intentionally left blank CHAPTER The Why of Price Valuation F undamental analysis focuses on the why of price valuation for a stock, an index, or a currency. Multiple factors affect the value of an asset or market, and in this part of the book we attempt to explain those factors in simplified terms. We need to be aware that fundamentals move the market on both the short-term and long-term levels because that can provide the basis for a trading decision. However, when it comes to exe- cution, which involves the when and the how in the trading equation, we rely on additional information to supplement the fundamentals. Fundamental analysis historically has been used to evaluate the worth of a company by valuing its stock price. As we have seen new markets emerge and new financial instruments develop, fundamental analysis has been used to price those markets and instruments as well. When applied to the forex market, fundamental analysis has a twofold purpose: deter- mining the short-term impact on currency prices and forecast- ing long-term trends. We will examine some of the underlying 21 2 forces that affect fundamentals. We’ve chosen to focus on U.S. fundamentals because the U.S. dollar is involved in approximately 70 percent of currency transactions. The over- all generalizations we make about U.S. economic indicators and U.S. interest rates apply in the same manner to other coun- tries’ fundamentals and interest rates in relation to their cur- rency valuations. Keep in mind that currency trading is relative from currency to currency and economy to economy as the business cycle evolves. When it comes to buying and selling currencies at different times in the global business cycle, it is not about identifying the strongest currency so much as it is a matter of identifying the least weak currency. Effect of the Business Climate The same forces that affect the value of a business have an impact on the price of currencies. In fundamental terms, a company is valued on the basis of its balance sheet and cur- rent or future income as well as intangible factors that will affect that future income, including business model and plan, management and leadership, competitive advantage, and adherence to laws and regulations. External factors that affect a company’s value include the valuation of the industry in which it competes, the company’s rank or market share in that industry, interest rates, and current or pending legislation that will affect regulation of the industry. If a company’s products or services are selling at a profit and are expected to continue doing that and if other market conditions are favorable, that company’s value, or stock, should go up. It is said that the Mastering the Currency Market 22 company is fundamentally sound in those circumstances, and the market reflects that value. If sales slow, expenses are higher than expected, or external factors affecting profitabil- ity change in a negative direction, the stock price should go down. If sales are steady and the company makes no appre- ciable gains, the stock may go sideways. Similar concepts apply to countries and geographic unions. In very simplified terms, if the companies and citizens in a country are producing more than they spend and taxes are sufficient to cover expenses, increased income in the form of tax receipts flows into government coffers. Because most businesses continually seek to improve, there is increased competition for money, or funding, as individuals and businesses borrow money to expand. An increased rate of borrowing money leads to increases in inter- est rates, which will attract capital from investors seeking a higher yield for their savings and investments and thus cause an increase in tax receipts. Job growth is healthy when businesses are spending money to stay competitive. In a healthy worldwide environment, the stronger an individual country’s economy is, the more demand there is for stocks and other investments denominated in that currency, the more pressure there is for higher interest rates, and the stronger the currency is. Conversely, the slower the economy is, the more pressure it puts on stock prices as investors exit investments in search of higher yields and on central bankers to lower interest rates, further decreasing the return on investments valued in that country’s currency; in that case, the country’s currency becomes weaker. To generalize about the impact of a positive global business climate, it can be said that higher interest rates mean a stronger currency and that a weaker currency leads to lower interest The Why of Price Valuation 23 rates. The most direct link between interest rates and currency values is the level of business activity. If business activity is growing, there is room for higher interest rates created by demand for more money and thus a stronger currency. If busi- ness activity is contracting, higher interest rates are a threat to commerce and interest rates may have to be lowered, with the effect being a weaker currency. In times of global economic uncertainty and recession, how- ever, traders and investors favor lower-yielding currencies because governments and businesses in those countries will be relatively less handicapped by lower borrowing costs (interest rates) in a slowing economic environment. In summer 2008 we saw a good example of this as global stock markets turned lower, erasing the gains of the previous two years. Investors around the world went from thinking about the return on their investments to being concerned about the return of their investments. With governments, businesses, and individuals all trying to exit their previously higher-yielding investments at the same time, cur- rencies with higher-yielding interest rates fell sharply as money poured out of the British, European, Canadian, Australian, and New Zealand currencies and into the lower-yielding U.S. dollar and Japanese yen. The sharp reevaluation of currencies in the third and fourth quarters of 2008 also pointed out the fact that the currency market is a self-correcting mechanism. What strengthens a currency initially also can weaken it as interest rates become too high and currency valuations become too inflated relative to those of competing countries and unions. Although Canadian citizens felt proud as their currency rose from 0.60 to 0.80 against that of their U.S. neighbors, Canadian businesspeople felt concern and then fear as the looney kept Mastering the Currency Market 24 on strengthening from 0.80 to 1.00 against, or on par with, the U.S. currency. This 40 percent increase in the looney made it very easy for American farmers and manufacturers to take business from their Canadian counterparts because the cost of American feed and products was so much lower compared with the Canadian than it had been just three or four years ear- lier. As business shifted away from Canada, the looney turned and was sold off, and the Canadian government cut interest rates accordingly. Like a pendulum that has swung too far, it can be said that the weight of a stronger currency can cause its value to swing lower. It is this characteristic of a free enterprise system with floating currency values that ideally ensures that the best products and services at the most competitive prices are what will set economic standards going forward, not polit- ical or nationalistic considerations. Interest Rates and the Carry Trade As we saw with regard to the effects the overall business envi- ronment has on currencies, interest rates play a key role. One way to take advantage of interest rate differentials between countries is by buying a currency with a higher interest rate and collecting that interest and then selling a currency with a lower interest rate; when the short position pays the interest rate, this is called the carry trade. In times of global economic expansion, investors and traders make money by using this strategy. A typical example from a couple of years ago would be buying U.S. dollars and selling Japanese yen; in trading par- lance this is known as going long USDJPY. If interest rates The Why of Price Valuation 25 were 3.0 percent in the United States and 0.5 percent in Japan, the position would yield, or “carry,” an annual rate of 2.5 percent. If the trader had on a position of long five stan- dard lots, or $500,000, he would collect 2.5 percent annually on the $500,000 even if he had only $10,000 in his account. That may sound like a lot of money at first, but consider the risk that individual would be incurring to capture that $35 a day in interest. By holding a $500,000 position in a $10,000 account, the trader could lose everything if USDJPY moved just 2 percent. In today’s marketplace a 2 percent move in a single day for a currency pair is not unreasonable. In a much larger account, in a healthy economic climate, and with the account managed by professionals, this arbitrage strategy makes a lot of sense. Professional traders understand this and have taken advantage of interest rate differentials in the global marketplace during times of economic expansion. For an individual with little experience and a small account, the strategy is inadvisable and dangerous. The last time the carry trade was working, from mid-2005 to mid-2007, it was working very well. Prices of the higher- yielding currencies raced higher while prices of the lower- yielding currencies stood still or even moved lower. What this meant was not only that buyers, or “longs,” in the carry trade were capturing the interest on their positions but that they were reaping the traders’ reward as their positions increased in value. Individuals with little experience were accumulat- ing larger and larger long positions and calling themselves traders. You probably can guess how this ended. Prices plum- meted violently at the beginning of 2008 as speculative monies vanished when stock and real estate markets fell Mastering the Currency Market 26 sharply after their inflated advances earlier in the decade. After a long pause through the spring and early summer of 2008, the sell-off accelerated again in mid-2008 as carry trad- ers with only a few years’ experience learned the hard way that what goes up comes down. They also learned that earn- ing a few pips a day on a carry trade was not trading at all. The bright side of this situation for experienced traders was that after the carry trade evaporated, two-way trade resumed. After the majority of the speculative money was wiped out, prices were free to move up and down, which is what mar- kets do in normal conditions. Inflation and Commodities An important link between interest rates and currency values is commodity inflation, which, unlike an individual area or country’s business activity, affects all economies. As inflation rises and prices spiral upward, some people quickly start to buy up future supplies of basic necessities as insurance against higher prices in the future. In that scenario, prices go up not because of healthy business activity but because of uncertainty and fear—and fear moves markets. In that scenario the gov- ernment can increase the interest rate earned on cash deposits to get individuals to sell off their stockpiles of supplies in exchange for cash and the increased dividend created by higher interest rates. This seems a responsible action but does not work in all cases. Some individuals are inclined to hang on to their supplies rather than take the cash, and attempts at easing inflation can be thwarted. The Why of Price Valuation 27 Businesses and economies around the world wrestled with a very similar fundamental problem with the supply of crude oil from 2005 through 2008. Crude supplies were shrinking as worldwide demand increased, and that caused the price of crude to jump from under $40 per barrel in 2004 to a high of $140 in July 2008. That created additional expenses and com- modity shortages and the fundamental complications that go along with that situation. Those problems had not been in place just a few years before. Countries that had their own supplies of crude didn’t feel the need to raise interest rates, whereas some countries and regions that did not have their own sup- plies did. The interest rate differentials created opportunities for traders but caused much confusion for the economists and politicians charged with solving those complex problems. Generally, a rise in commodity inflation will cause a rise in the value of the currency of a country that has large supplies of that commodity. Again, however, it is important to keep in mind that currency valuations are relative. Many analysts and commenta- tors called the Canadian and Australian currencies commodity currencies because those countries have an abundant supply of commodities, and as the price of commodities moved higher from 2002 through 2008, so did those two currencies. The United States also has an abundance of commodities, whereas Switzerland does not, yet the U.S. currency went down and the Swiss currency increased sharply over that period. This leads to the question, was there really a relationship between commodi- ties going up and these so-called commodity currencies going up, or did they just happen to be different investment classes that were going up at the same time? As it turned out, the Canadian currency topped out a full seven months before crude Mastering the Currency Market 28 oil peaked, whereas gold peaked four months ahead of the Australian dollar. As of December 2008, gold was off its all-time high by just 15 percent and the Australian currency was off its high by 30 percent. We believe that both commodities and currencies are com- plex vehicles that should be traded individually on the basis of price movement. There are relationships between different mar- kets and asset classes, but relationships by definition change, particularly when one is comparing complex pricing processes such as commodities and currencies. “Don’t get caught trading wheat in the corn pit” is an old Chicago trading adage. It can be said that the same thing is true when one is trading a cur- rency that is based on a commodity’s price or vice versa. Commodity inflation overall adds uncertainty to markets as governments try to offset the effects of rising and falling prices with interest rate or other policy changes when often it is best to let the markets correct themselves. Uncertainty in the markets produces price movement, which is always beneficial for traders. Consumer Habits One also must take into account the effects that prosperity and the appearance of continued prosperity have on financial mar- kets; this also is known as the boom-bust cycle. When economies are strong, such as that of the United States in the 1990s and from 2003 through 2007, it creates the expectation that strong eco- nomic growth will continue. As is often the case in economics and markets, the seeds for the downturn were created by The Why of Price Valuation 29 [...]... Fundamental traders, economists, and market analysts gauge economic activity by studying and interpreting economic reports and readings released by companies and government agencies These news releases are available at a number of online sites We use www.ForexFactory.com, which is one of the leading sites in the forex industry for news On the front page of its Web site there is a tab for “Calendar.” If you click... majors, having led the rally in 2006 and 2007 and having topped in 2008 and led the majors lower from there The Japanese yen is a very influential currency in that the Japanese economy is the second largest in the world and that nation’s currency is the primary Asian representative in the forex markets The central bank of Japan is the force behind the yen and is known for being more active than the other... currency strong, such as a growing business environment and firming interest rates, in time will have the opposite effect as that demand will allow those countries’ trading partners with cheaper currencies and lower interest rates to undercut their prices, leading to slower growth and lower interest rates in that country • If you are new to trading and economics, do not base trades solely on fundamentals... though: The volatility created by economic uncertainty is a feeding bell for professional traders There are many nuances in the fundamental valuations of stocks, other financial instruments, and currencies, and we’ve taken a look at the major ones As we’ve seen, there are four important factors in the pricing process for financial markets: 1 Current business conditions, meaning income and cash on hand for companies... knee-jerk reaction lower to a CPI number that was higher than expected However, once the price settles down and finds support around the previous session’s low, the market turns and trades higher, in line with the higher than anticipated U.S inflation numbers Consumer Confidence The index of consumer confidence measures the level of economic optimism of consumers, based on their savings and spending activities;... p.m to midnight Eastern Standard Time 48 P A R T Technical Analysis 3 This page intentionally left blank C H A P T E R 3 Charts for Trading F or technical analysts, the art of trading starts with the chart A chart is a sequence of prices plotted vertically over a horizontal time frame, with each individual price bar, or candle, marking the open, high, low, and last price for a particular time period:... Charting and technical analysis overall are based on the assumption that actual price action is more significant than the information that has been reported to be the cause of that action We assume that all known market information already has been deciphered by market participants and therefore is reflected in the last price We don’t doubt that fundamental information is often the driving force behind... index consists of 500 of the top U.S corporations It provides a forward look on the health of some of the largest companies in the world and is thus a good gauge of the economy overall U.S Treasury bonds and notes These influential financial instruments provide a direct look at current and future interest rates as well as gauging demand for government securities U.S dollar index This currency index shows... economic releases for the week and their expected impact Releases with a red icon have the highest expected level of impact Another great resource is www.munibondadvisor.com/EconomicIndicators.htm, which links readers directly to the source for every news release Figure 2-1 shows a summary spreadsheet of the most influential news releases for the United States, including the typical release dates and the net... existing favorable conditions, and this report proves our thesis was correct, so let’s take some money off the table and put it in our pockets now because we don’t know if things can get much better than this.” “A bird in the hand is better than two in the bush” is standard operating procedure for many who make a living risking their earnings in the marketplace The way traders and markets react to the different . more demand there is for stocks and other investments denominated in that currency, the more pressure there is for higher interest rates, and the stronger the currency is. Conversely, the slower. is room for higher interest rates created by demand for more money and thus a stronger currency. If busi- ness activity is contracting, higher interest rates are a threat to commerce and interest. price those markets and instruments as well. When applied to the forex market, fundamental analysis has a twofold purpose: deter- mining the short-term impact on currency prices and forecast- ing